While equity-linked derivatives dominate South Korean structured products, Hana Financial Investment (HFI) has diversified into the broader derivatives-linked securities (DLS) space. That move is paying off now amid choppy markets.
The firm is the leader in the derivatives-linked securities market, with a 16% market share as of the end of 2017 – up from 11.3% three years earlier. In the crowded equity-linked securities (ELS) market, its share has nudged up one percentage point to 8.5% in the same period. HFI ended the first half of 2018 with further gains, taking its share of the pie to 9% in ELS and almost a quarter in DLS.
“HFI’s main goal in ELS/DLS markets is to provide pricing-competitive and innovative structured payoffs with attractive risk/return profiles, whilst being able to efficiently recycle our own risk positions,” says Ken Woo, head of the equities division at HFI.
The two most popular investment formats in the Korean structured product markets are ELS and DLS, which can be issued by securities firms with over-the-counter licences.
“The products have very different characteristics; ELS payoffs must be linked to single stock(s) and/or equity indexes. These days, the most popular ELS underlying is a basket of global equity indexes such as the S&P 500, Euro Stoxx 50, Kospi 200, HSCEI and Nikkei 225. On the other hand, DLS payoffs can be linked to many different types of asset class, such as rates, credit, hybrid with equities, and so on.”
The returns these derivatives have provided amid record low interest rates have lured retail investors towards such structured products. Korean ELS sales volume reached $59 billion in 2017, up from $46 billion in 2014, and DLS sales volume nearly doubled over the same period, reaching $16.7 billion in 2017. ELS volumes surged to about $50 billion in the first six months of the year but have since slumped as the emerging market crisis roils Asian stock markets. But volumes of DLS with a steady payoff have remained intact.
“I believe both ELS and DLS have successfully settled down as alternative asset classes for various types of investor seeking customised yield enhancement within pre-set/appropriate risk [paramaters]. In many cases, underlying assets’ volatilities, forward prices and correlation are the main sources of yield enhancement,” says Ken.
HFI’s main goal in ELS/DLS markets is to provide pricing-competitive and innovative structured payoffs with attractive risk/return profiles, whilst being able to efficiently recycle our own risk positions
Ken Woo, Hana Financial Investment
The complexity of the payoffs differs; most ELS payoffs have features such as autocallable mechanisms, correlation effects and quanto components, which may be difficult to fully hedge in the listed or interbank markets where only plain vanilla payoffs are being traded. However, DLS payoffs vary from straightforward examples such as those in credit-linked products to highly complex ones.
In 2015, for instance, HFI decided to offer reverse convertibles with tenors of between six and 12 months, featuring payoffs linked to five-year or 10-year US dollar constant maturity swaps (CMS). The offer was prompted by signals of progressive rate hikes from the US Federal Reserve and the fact that clients who thought US interest rates were unlikely to fall significantly in the short term wished to benefit from this view.
After the rate hikes, US dollar CMS rates went up and DLS investors could achieve their target yield enhancement. Due to the nature of the reverse convertible payoffs, however, the source of that yield enhancement shrank substantially after US dollar CMS rates almost doubled. So from March 2017, HFI began to use sterling CMS – sometimes in addition to US dollar CMS, with autocallable or issuer-callable features.
HFI’s DLS products linked to various global rates introduce new investment possibilities to retail and private banking customers in the DLS market. Global rates, previously considered as an exclusive asset class for institutional clients, have established a presence as one of the main asset classes for retail and private banking customers thanks to HFI’s wide range of offerings in global rates underlyings.
The complexity of hedging is similarly varied. As ELS are typically linked to a basket of global equity indexes, the related listed futures and options are traded on major exchanges with a very tight bid/offer spread and good liquidity. However, DLS can be linked to a range of asset classes, some of which are only traded in over-the-counter or interbank markets, which can create higher slippage costs due to the wider bid/offer spreads given by market-makers.
“In the ELS market, HFI has established various cross-hedging schemes whereby we can recycle a majority of exotic risk, which could be very challenging to hedge under distressed market conditions, with major global investment banks, while we manage residual plain-vanilla-like positions being less risky,” says Ken. “Moreover, these idea-driven cross-hedging schemes could be a great stepping stone for HFI to further develop our in-house hedging and risk management capabilities. In the DLS market, HFI tends to provide in-house pricings for simple payoffs, such as simple credit-linked DLS. For complex payoffs with global underlyings that HFI does not actively trade, we use back-to-back business models where we can hedge out most market risks via global investment banks.”
The firm has also had to carefully consider how to recycle the embedded market risks in ELS and DLS based on available hedging tools and their liquidity.
It has worked closely with major local banks on the distribution side and global investment banks on the product manufacturing side, whilst building out its risk management technology and operations to deliver greater efficiency.
“HFI has continuously provided innovative and diversified structured products, serving a successful business partnership with our company,” says a wealth manager at a Korean lender.
“HFI always puts mutual success with our clients and business partners as a top priority,” Ken says. “In addition to being well connected with different types of market participant, HFI has been investing substantially in the further development of our trading and risk management capabilities.”